February 10 - Financial Times (John Authers): “The Importance of Bubbles That Did Not Burst:”

“Is there really such a thing as a market bubble? I feel almost heretical answering this question. I and most readers have lived through two decades that were dominated by two vast investment bubbles and the attempt to deal with their consequences when they burst. Getting into definitions is beside the point. As US Supreme Court Justice Potter Stewart once said to define pornography: ‘I know it when I see it.’ And there is no point in arguing that the dotcom bubble that came to a head in 2000, or the credit bubble that burst seven years later, were not bubbles. I know a bubble when I see one, and they were bubbles. For those of my generation, spotting bubbles before they get too big, and thwarting them, seems to be vital for regulators and investors alike.”

“But in a great new compendium on financial history, several writers make the same points. The number of bubbles in history is very small. That makes it hard to draw any valid inferences from them. Further, definition is a real problem, and not just one for linguistic nitpickers. History’s acknowledged bubbles all have one critical factor in common; they burst. But that gives us a one-sided view. We need to look at those bubbles that did not burst and the crises that did not happen.”

We’re at the stage where there’s impassioned pushback against the Bubble Thesis. To most, it’s long been totally discredited. Even those sympathetic to Bubble analysis now question why the current backdrop cannot be sustained. “The number of bubbles in history is very small.” Most booms did not burst. So why then must the current boom end in crisis - when most don’t? It has become fashionable for writers to try to convince us that such an extraordinary backdrop need not end extraordinarily.

There’s great confusion that I wish could be clarified. I define Bubbles generally as “a self-reinforcing but inevitably unsustainable inflation.” There are numerous types of Bubbles. Most definitions and research (as was the case with the analysis cited by the FT’s Authers) focus specifically on asset prices (“an extreme acceleration in share prices. In one version, [Yale’s Will Goetzmann] required them to double in a year — which excluded the dotcom bubble and the Great Crash of 1929. To keep them in, he also tried a softer version where stocks doubled in three years”).

Behind every consequential Bubble is an inflation in underlying Credit. My analysis focuses on the nature of the monetary expansion responsible for the asset inflation. I’m less concerned with P/E ratios and valuation than I am Credit expansions and the nature of risk intermediation. Earnings are important, but more critical to the analysis is the degree to which they (and “fundamentals” more generally) are being inflated by monetary factors - and whether such inflation is sustainable or susceptible.

Credit Dynamics are key. Mr. Authers refers to the “dot.com” and “Credit” Bubbles. Yet the nineties Bubble was fueled by extraordinary expansions in GSE Credit, securitizations and corporate debt. Internet stocks inflated spectacularly, but in the grand scheme of the Bubble were rather inconsequential. The Bubble faltered initially in 2000 with the sharp reversal in technology stocks. Less embedded in memory is the near breakdown in corporate Credit back in 2002. The resulting aggressive Fed-induced reflation then spurred a doubling of mortgage Credit in just over six years. The transformation of risky Credit into perceived safe money-like securities (“Wall Street Alchemy”) was integral to both “tech” and “mortgage finance” Bubble periods. The fact that dot.com price inflation and overvaluation greatly exceeded that of home prices is meaningless.

When I initially titled my weekly writings the “Credit Bubble Bulletin” back in 1999, I anticipated that “Bubble” would remain in the title only on a short-term basis. And indeed, I thought the Bubble had burst in 2000/2001 and then again in 2008. But in both instances Credit Dynamics and resurgent monetary inflation made it clear to me that a more powerful Bubble had reemerged. Whether one prefers to date the beginning of the Great Credit Bubble 1992, 1987 or even 1971, it’s been inflating now for quite a long time. Too be sure, the expansion of government Credit over the past eight years puts mortgage Credit and other excesses to shame.

I would argue that price distortions and risk misperceptions similarly overshadow those from the mortgage finance Bubble period.

Of course, the vast majority have become convinced that the boom is sustainable. Indeed, analysis these days is eerily reminiscent of “permanent plateau” jubilation from 1929. The bullish perspective sees an improving global economy and a powerful pro-growth agenda unfolding in the U.S. Worries about debt, China and such matters have turned stale. A contrary argument focuses on Credit Dynamics and the unsustainability of today’s unique monetary and market backdrops.

Over the years, I’ve made the point that a Bubble financed by junk bonds would not create a systemic issue. There are, after all, limits to the demand for high-risk debt. Long before such a boom could go to prolonged and dangerous extremes (imparting deep structural maladjustment), investors would shy away from increasingly unattractive Credit issued in clear excess. The boom would lose its monetary fuel.

I define contemporary “money” as a financial claim perceived as a safe and liquid store of (nominal) value. Money these days is Credit, but a special type of Credit. Unlike junk bonds, “money” enjoys essentially insatiable demand. As such, a boom fueled by “money” is a quite different animal than our above junk bond example. I would posit that a prolonged inflation of perceived safe “money” by its nature ensures far-reaching risk distortions. For one, Bubbles fueled by “money” appear especially sustainable, while a prolonged inflation of “money” virtually ensures a destabilizing crisis of confidence. Governments throughout history have abused money. Contemporary central bankers took it to a whole new level.

I referred to the “Moneyness of Credit” throughout the mortgage finance Bubble period, a boom financed largely by “AAA” money-like MBS, ABS and “repo” Credit. Back in 2009, with the arrival of enormous expansions of central bank Credit and fiscal deficits coupled with the Fed’s reflationary policies targeting the securities markets, I proffered the “global government finance Bubble” and the “Moneyness of Risk Assets.”

I understand the rationality of complacency. I appreciate that confidence runs high that this boom need not end badly. Those willing to bet on central banks have won, repeatedly. “Money” – to the tune of Trillions – has flowed with great abundance to managers and fund structures programmed to disregard risk. The consensus view holds that huge amounts of buying power await a market dip. Moreover, only “dips” at this point would side against the mighty bull.

There’s no mystery why the VIX ended the week near ten-year lows. And I don’t believe, as explained by an analyst on Bloomberg television, that improved global economic fundamentals explain unusually low implied equities market volatilities (VIX). The VIX clearly does not reflect global political and geopolitical uncertainties. Instead, it’s more a reflection of robust global “money” and Credit growth and the perception that central bankers will ensure ongoing monetary inflation while backstopping global securities markets. With impatient dip buyers and central bankers not about to allow pullbacks to gain momentum, why not write put options and other derivative market “insurance”? Selling flood insurance during a drought. Central bankers have promised abundant liquidity and persistent loose financial conditions, while placing a floor under stock prices and a ceiling over market yields.

Returning to John Authers, when it comes to the current Bubble backdrop, I take exception to “I know it when I see it.” It’s the nature of Bubbles that the more conspicuous they appear the less systemic their impact. I point to the example of the conspicuous “tech” Bubble and much more systemic Bubble in “mortgage finance.” Even in the craziness of 2006 and early-2007, the truth of the matter is that few at the time recognized the Bubble.

Today’s Bubble is global, and it resides at the very heart of contemporary electronic “money.”

This means, as we’ve already witnessed, that it can inflate almost indefinitely, at the discretion of a small group of central bankers and so long as their Credit is readily accepted. It’s unique in financial history, the consequence of the runaway global experiment in unfettered “money” and Credit. Even after tens of Trillions of issuance, the demand for central bank Credit (“money”) and (money-like) government debt is today as insatiable as ever. The downside is that this prolonged Bubble has inflated most assets across the globe. It has evolved to be deeply systemic on a global basis, with unprecedented distortions in risk perceptions and asset prices more generally.

There’s a reason why crises tend to erupt in the money markets. Panic quickly ensues when markets suddenly sense their perceived safe and liquid holdings are at risk. The VIX is low today because of the perception that global financial institutions remain flush with liquidity, buoyed by rising asset prices, and under the safekeeping of central bankers and government officials. The perception of moneyness pervades “repo” markets, and robust repo and securities financing markets convey easy access to liquidity for securities dealers and derivative players.

The VIX is low because of extraordinary confidence in counterparties and the functioning of derivatives markets more generally. The VIX is low based on faith that Beijing will backstop China’s entire over-heated Credit system.

It’s worth recalling that a year ago bank stocks were under intense pressure around the world.

For example, from 2015 highs to 2016 lows, Japanese stocks dropped almost 50%. Similar losses were shared by banks throughout Asia and Europe. Especially in early-2016, fears were mounting that a Credit crisis in China could unleash financial and economic stress around the globe. As a weak link in global finance, European banks were feeling the contagion. In short, there was heightened nervousness that risk was seeping back into the international daisy-chain of various bank liabilities. “Moneyness” – a now global phenomenon - was in jeopardy.

Well, “whatever it takes” – from strong-handed Chinese officials, from the inflationist BOJ and ECB, and from a dovish Fed - nipped potential crisis in the bud. Promises of a couple Trillion additional QE crushed global yields and kept the game going. Markets have inflated significantly over the past year. What will central banks do for an encore?

It is a principal thesis of Bubble Analysis that, once commenced, monetary inflations turn progressively difficult to control. Credit inflations raise myriad price levels throughout the economy and asset markets. Especially after years of inflating asset and securities markets, it will not be possible for global central bankers to walk away from QE without major consequences. The world is currently at peak QE, with major uncertainties surrounding future operations.

Europe, in particular, has begun to fret the effects of waning QE. I’ve highlighted the recent significant rise in sovereign yields in Portugal, Italy, Spain and Greece. I’ve noted the major widening of spreads between French and German bonds yields.

Similarly concerning, European sovereign spreads continued to widened. Safe haven German bund yields dropped nine bps to a five-week low 0.32%. The France to Germany 10-year yield spread widened seven to 74 bps, the widest going all the way back to tumultuous 2012. Italy’s spread widened 10 to 195 bps, trading this week at the widest level since early-2014. Spain was 11 wider to 138 bps, the widest since last June.

U.S. bank stocks also lagged this week’s market rally. But with Chinese and Asian banks enjoying strong gains, it might be too early to make much out of the return of European bank concerns. Yet it does have to start somewhere. ECB policies have encouraged Europe’s banks to (again) load up on government bonds at incredibly inflated prices. Now what?

Here in the U.S., markets this week took comfort in a relatively well-contained President Trump. He greeted Japanese Prime Minister Abe with a big, warm hug. He sent a letter to Chinese President Xi, stating that his Administration would honor the “One China” policy.

While perhaps somewhat mollified by his correspondence, Chinese leadership must be deeply suspicious of Trump’s zeal for chumming around with Shinzo (Abe). But at least for now, our President was trying to get along with (most) folks. Markets got along well with the idea of “phenomenal” tax cuts.

“Taxation is the price we pay for failing to build a civilized society.”

– Mark Skousen

“Government’s view of the economy could be summed up in a few short phrases: If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it.”

– Ronald Reagan

Taxation is almost never an exciting subject, nor do we want it to be. The best tax system would be silent and unobtrusive. It would raise enough revenue to cover essential government functions and not a penny more. Sadly, our US system is nowhere near the ideal.

In part one of this series, I talked about whether the new tax proposals would actually create jobs and discussed the proposed “Border Adjustment Tax” and some of its possible complications. In part two, today, we will look more closely at the rest of the tax proposals.

Then next week we will go much deeper into the BAT and then into what I think the tax system should actually look like, which will be far different from anything I’ve suggested in the past. That discussion will make more sense if we have placed the ideas in full context. That is today’s objective.

The BAT is not a stand-alone policy. It is one component of a broader House Republican tax reform plan, which in turn is part of an even broader federal government reform proposal called “A Better Way.” In theory, the different parts all work together, which is good but makes it hard to discuss any one element in isolation.

In this series, I’m looking specifically at the tax-reform portion of the Better Way proposal.

It has other planks on national security, health care, poverty, and more. They are important, and I may discuss them in the future, but let’s leave them aside for now.

I must also note that I am not a CPA or any other sort of tax expert, and you should not make any financial or tax decisions based on what I say here. Please consult your own tax advisor for individual advice.

With those caveats, we’ll look at why we need tax reform and how the Better Way plan tries to deliver it. I want to say up front that I respect the plan’s authors for taking on this very difficult task. As you’ll see, though, I foresee major problems with some of their proposals. I hope they’ll take my criticism constructively and modify the plans to work better for everyone.

The Problem with Taxes

I will begin with an assumption I know some readers will resist: Government is necessary.

Some of my friends and readers are anarchists, libertarians, or otherwise believe that government is inherently evil or counterproductive. I respect your sincerity, but I disagree.

Now, this is not to say that we need as much government as currently exists, or that everything governments do is useful. A great deal of it is not. Nevertheless, I believe we need some level of government to maintain civilization. That means we have to pay for the things government does. Hence, we have taxes.

The goal of tax policy should be simple: raise the necessary revenue to pay for whatever government actually, minimally needs to do. And government should do those things as fairly and neutrally as possible. Is that what happens? No.

We use tax policy to reward certain behaviors and/or interest groups while discouraging or punishing others. Using the tax code in this way is somewhat like using a baseball bat for heart surgery: It’s a blunt instrument, and not everyone will like the result. Nevertheless, that is what we do.

The outcome, over years and decades of incremental amendments and exceptions, is that we now have a system that no one fully understands, one that creates all manner of twisted, counterproductive incentives. Large parts of our economy, indeed entire industries, exist only because the tax system makes them profitable.

Others don’t exist because the tax system makes them unrewarding.

Why do we tolerate this? Because, as much as we complain about the tax system, we all get something out of it. Virtually everyone has a vested interest in keeping some part of the current system intact. We also fear that any change will only make taxes worse – a perfectly rational fear, too. These concerns make change difficult.

So, to the extent that the House Republicans want to give us a better system, I applaud them for trying. Whether their ideas will work as planned is another question, which I tried to answer in part last week and will continue to explore today. I think there will be significant unintended consequences, no matter how well-intentioned the efforts.

You see, you simply cannot overhaul our current tax system, as invasive as it is, without creating winners and losers. As the old saying goes, if you want to make an omelet, you have to break some eggs. One man’s tax efficiency is another man’s tax loss. That’s just the nature of taxation. As we will see next week, I think the ideal tax system is one that is as neutral as possible and simply keeps the playing field level so that new businesses, entrepreneurs, and current enterprises, from the smallest to the largest, can figure out how to best deliver to us the products and services we need.

Correction from last week: I said last week that the staff of House Ways and Means Chairman Kevin Brady were very kind to meet with me but that our conversations were background, i.e., off the record. They also said my separate conversation with the chairman himself would be on the record. The way I explained this to you was unintentionally ambiguous. Chairman Brady’s staff read last week’s letter and politely asked me whether I had understood our agreement. So to clarify: The conversation with Chairman Brady was completely ON the record, and I will be quoting him again next week. I apologize for the confusion.

A Better Way?

As I travel around the country, I am rather amazed to see how few people actually understand what is being proposed on the tax front. Those of you who have already done a deep dive on this can skip through to the next section, but the rest of you may find the following not only interesting but very important to understand.

So here is what is being proposed as the new tax system. This is how they describe the plan in their own words (and their own font, too).

Simpler, fairer, and flatter. Jobs and growth. An “IRS that puts taxpayers first.” All this sounds wonderful compared to what we have. But how will they accomplish these lofty goals?

The Better Way blueprint changes both individual and corporate income tax policies.

Highlights for individual and family taxpayers include:

• A three-bracket tax rate schedule with the top rate reduced to only 33%

Here is a handy comparison chart from the Tax Policy Center, showing both the current rates and new rates by income level.

Different rates apply for capital gains and dividend income. The following chart from the Tax Foundation shows those rates under current law and the House GOP proposal.

Note that the plan makes these rates even more attractive with a 50% deduction for capital gains, dividends, and interest income.

For the most part we see marginal rates going down, though the revised deductions and other features make direct comparisons difficult. For instance, look at that 33% top rate, which begins at $202,150 for single taxpayers and $255,450 for married couples filing jointly. If this plan is enacted, very few people will pay 33%, firstly because not all that many people make that much income, but also because those who do are frequently self-employed professionals or business owners. This is incredibly important. Self-employed individuals will essentially have a top tax rate of 25% – assuming they can figure out reasonably quickly how to game the system (and my bet is they can).

They haven’t written all the fine rules and details yet, but given the system as proposed, care to make a wager with me as to how many self-employed individuals will manage to have their actual on-the-book W-2 wages drop to under $200,000 and the rest of their earnings become self-employed income? Do you want to take the over, or the under, on 90% of them doing so? (The other 10% being simply clueless.) I would, of course, take the over. Do you want the under? I didn’t think so.

Again, the tax rate on income for proprietorship and pass-through entities (LLCs, sub-S corporations, and the like) tops out at 25% under this plan. High-earners who aren’t already business owners or contractors will reorganize. Something similar happened with the 1986 Reagan tax reform.

Sidebar: As I have pointed out in previous letters, the flawed data that the French economist Thomas Piketty uses to describe wealth and income disparities (which do of course exist) is actually government data, although he tortures the numbers and ignores what doesn’t fit his uber-socialist agenda. Amazingly, in 1986 we saw the biggest one-year leap in US income in history. (It was truly massive.) Except that there was no actual bottom-line difference. It was all an accounting difference. President Reagan and Congress shifted corporate taxes among different types of corporations and personal earners; and not so amazingly, almost everybody (including your humble analyst) reorganized their businesses so that their income fell into the lower tax rates. What Piketty records as a huge spike in income was actually just a simple tax reorganization.

If this presently proposed tax reform passes as currently written, a very similar reorganization will happen. Trust me on this one. By the way, this response is not a bad thing. It’s just something that happens when you change the rules on taxation. Everybody organizes their businesses so as to pay the least possible amount in taxes.

OK, even more tax-gaming opportunities: Maybe your LLC becomes a C corp. (Sorry to foreign readers for the inside-baseball lingo!) Your income now becomes “W-2 wages” that you hold under $200,000. And then you dividend the rest to your bank account at 16.5%. After paying 39.6% in recent years, that will feel like tax heaven. And will that dividend be subject to the Medicare surcharge of 4%? The details on how those rules will be applied are going to be very important. And as I further note below, that strategy will only work for certain types of companies! More winners and losers!

Other changes to corporate income taxes include:

• Reduced top rate from 35% to 20%

• Elimination of the corporate AMT

• Immediate, full deduction for capital investment expenditures

• Indefinite carryforward of net operating losses

• Interest on future loans nondeductible

• Elimination of most deductions except the research and development credit

• Exemption of foreign-subsidiary dividends from US tax

• US companies can repatriate currently deferred foreign cash holdings at an 8.75% tax rate

Let me say that some of these features are very appealing. Getting rid of the AMT, both corporate and private, for example, is a very good thing. (For what it’s worth, I seem to be able to avoid the AMT most years, so this really doesn’t affect me; but I know it is a large hassle to a lot of people who file income taxes.) Many of the other changes really will make it much easier and less complicated to pay taxes, and increasing the earned income tax credit and streamlining education tax benefits are both good things.

(Tax) Details, Details

The Better Way plan’s other elements will also bring about major changes in the way American businesses operate. I’m not sure anyone has truly thought these through yet.

Good-bye, depreciation and amortization. Businesses will be able to immediately “expense” (deduct from income) capital expenditures that formerly had to be split over many years. Build a factory this year, and the full construction costs will be deductible this year. Land costs will still have to be amortized. This simplifies bookkeeping, which is nice, but it will also have an impact on balance sheets.

Some businesses will have massive tax carry-forwards to match against future sales generated by the capital expenses. So we will really be trading depreciation accounting for tax carryforward accounting. I’m not sure this change will be an improvement and won’t be surprised to see weird side effects.

This also means that the actual effective corporate tax rate is going to be a LOT lower than 20% for most business, especially tech firms and manufacturers, biotech companies with large R & D outlays, and other firms with large capital costs. Business (like mine) that have little in the way of capital costs will get no advantage from turning into a C corp and going the dividend route with income. I would actually pay more going that route. Small manufacturing firms? Tax heaven.

Interest not deductible: Inability to deduct interest expense will discourage borrowing. That’s probably a good thing overall, but in some industries it could be catastrophic. (Note that the current plan would apply only to interest on future loans. I predict that if the policy goes forward, then unless they backdate the requirement, there will be a lot of loan business in the few months before it takes effect.)

Here again the benefits don’t get evenly distributed. Think about how the change will affect REITs, which generally use a lot of leverage and other structures that presently spin off cash flow paired with tax and interest deductions. Also, think of all the hedge funds and other investment tools that use leverage and deduct the cost. Knowing how “creative” our banking and real estate industries can be, this policy could open Pandora’s box. You can bet the accountants and tax lawyers are going to be watching the actual rulemaking process very closely.

Side issue: If there is no such thing as depreciation and amortization and interest expenses are not deductible, that will play havoc with measures like EBITDA, maybe even making the concepts useless. Maybe corporations will have to report actual earnings rather than game the system. No, that’s just a dream – they’ll figure out some other way to game earnings.

Foreign Operations: What the proposed tax policy does is encourage businesses to produce goods in the US and export them overseas.

I am going to stop here, because the next step is to address the issues surrounding the Border Adjustment Tax. And that means we have to address the trade issues the BAT will create. Plus, the Republican proponents of this bill assume that since it does something similar to what other countries are already doing, they won’t react or retaliate. Next week we will look at the large and potentially very serious impacts this change could have on currencies and global credit markets.

Some of the proponents of the BAT concept clearly don’t understand game theory. Once you change your status relative to the other players in the game (in this case the game of international trade), the other players always react. We will explore what that might mean.

We are nearing the end of a prolonged state of taxation equilibrium. To expect other global players not to react as we disrupt that equilibrium is naïve. That doesn’t mean that we don’t need to change the way our corporations are taxed, or that we shouldn’t give our corporations the same competitive advantages every other country gives their companies; but we have to think the proposed changes through in a way that understands multiplayer game theory. This exercise is especially important if you are an investor and your investments and/or your income are closely tied to how well the economy does.

There are some really exciting elements in this tax proposal. And then… The good news is that this plan is bold. The bad news (at least from my standpoint) is that it is not bold enough. Bluntly, getting the BAT approved by this Congress is going to be difficult. If you’re going to try to change things, then REALLY change things.

We will talk about what that means next week, too.

Boston, Cayman, and New Jersey

I’m finishing this letter back in Dallas, after having been in Orlando for three days. It turns out that I have to be in Boston Monday afternoon; and the weather gods are telling me that rather than wait till Monday and probably not get there because of snow, I need to leave this Sunday morning. After Boston, if everything works out according to plan, I will fly to Miami to meet Shane, and we will proceed to the Cayman Islands, where I speak at the Cayman Alternative Investment Summit (caymansummit.com/) and then spend a few days on the beach enjoying the weather and catching up on some of my reading.

This conference has a really solid lineup of speakers, and I’m looking forward to meeting a few new faces and spending time with old friends. I note that Arnold Schwarzenegger (the Terminator himself) will be speaking, along with a few other interesting “noneconomic” speakers. Plus, they host the Legends Tennis Tournament on Friday evening, which is quite the event.

Old friends Nouriel Roubini and Constance Hunter (the chief economist at KPMG) and I will be on a panel creatively titled “Guardians of the Galaxy: Have Central Bankers Lost the Plot?” I suspect that Nouriel and I will have differing views on the role of central banks. If nothing else, the session should be entertaining.

We are still working on the details, but I will be speaking to investors in a few towns in New Jersey in the middle of March. More as we firm things up.

We are finalizing the details of the Strategic Investment Conference, too. I am getting the final few keynoters lined up. You really don’t want to miss this conference. It takes place in Orlando May 22–25. We always sell out, so don’t wait till the last minute. I really hate telling people there’s no more room at the inn. You can register here.

It’s time to hit the send button. The emails are piling up in my inbox, and I really need to do something about it. I feel like that last quartet in the Robert Frost poem:

The woods are lovely, dark and deep,But I have promises to keep,And miles to go before I sleep,And miles to go before I sleep.

As Donald Trump rages against the world he inherited as president, America’s allies are worried—and rightly so.

WASHINGTON is in the grip of a revolution. The bleak cadence of last month’s inauguration was still in the air when Donald Trump lobbed the first Molotov cocktail of policies and executive orders against the capital’s brilliant-white porticos. He has not stopped. Quitting the Trans-Pacific Partnership, demanding a renegotiation of NAFTA and a wall with Mexico, overhauling immigration, warming to Brexit-bound Britain and Russia, cooling to the European Union, defending torture, attacking the press: onward he and his people charged, leaving the wreckage of received opinion smouldering in their wake. To his critics, Mr Trump is reckless and chaotic. Nowhere more so than in last week’s temporary ban on entry for citizens from seven Middle Eastern countries—drafted in secret, enacted in haste and unlikely to fulfil its declared aim of sparing America from terrorism. Even his Republican allies lamented that a fine, popular policy was marred by its execution.In politics chaos normally leads to failure. With Mr Trump, chaos seems to be part of the plan. Promises that sounded like hyperbole in the campaign now amount to a deadly serious revolt aimed at shaking up Washington and the world.

The Cocktail Party

To understand Mr Trump’s insurgency, start with the uses of outrage. In a divided America, where the other side is not just mistaken but malign, conflict is a political asset. The more Mr Trump used his stump speeches to offend polite opinion, the more his supporters were convinced that he really would evict the treacherous, greedy elite from their Washington salons.His grenade-chuckers-in-chief, Stephen Bannon and Stephen Miller, have now carried that logic into government. Every time demonstrators and the media rail against Mr Trump, it is proof that he must be doing something right. If the outpourings of the West Wing are chaotic, it only goes to show that Mr Trump is a man of action just as he promised. The secrecy and confusion of the immigration ban are a sign not of failure, but of how his people shun the self-serving experts who habitually subvert the popular will.The politics of conflict are harnessed to a world view that rejects decades of American foreign policy. Tactically, Mr Trump has little time for the multilateral bodies that govern everything from security to trade to the environment. He believes that lesser countries reap most of the rewards while America foots the bill. It can exploit its bargaining power to get a better deal by picking off countries one by one.Mr Bannon and others reject American diplomacy strategically, too. They believe multilateralism embodies an obsolete liberal internationalism. Today’s ideological struggle is not over universal human rights, but the defence of “Judeo-Christian” culture from the onslaught of other civilisations, in particular, Islam. Seen through this prism, the UN and the EU are obstacles and Vladimir Putin, for the moment, a potential ally.Nobody can say how firmly Mr Trump believes all this. Perhaps, amid the trappings of power, he will tire of guerrilla warfare. Perhaps a stockmarket correction will so unsettle the nation’s CEO that he will cast Mr Bannon out. Perhaps a crisis will force him into the arms of his chief of staff and his secretaries of defence and state, none of whom is quite the insurgent type. But don’t count on it happening soon. And don’t underestimate the harm that could be done first.

Talking Trumpish

Americans who reject Mr Trump will, naturally, fear most for what he could do to their own country. They are right to worry, but they gain some protection from their institutions and the law. In the world at large, however, checks on Mr Trump are few. The consequences could be grave.Without active American support and participation, the machinery of global co-operation could well fail. The World Trade Organisation would not be worthy of the name. The UN would fall into disuse. Countless treaties and conventions would be undermined. Although each one stands alone, together they form a system that binds America to its allies and projects its power across the world. Because habits of co-operation that were decades in the making cannot easily be put back together again, the harm would be lasting. In the spiral of distrust and recrimination, countries that are dissatisfied with the world will be tempted to change it—if necessary by force.What to do? The first task is to limit the damage. There is little point in cutting Mr Trump off. Moderate Republicans and America’s allies need to tell him why Mr Bannon and his co-ideologues are wrong. Even in the narrowest sense of American self-interest, their appetite for bilateralism is misguided, not least because the economic harm from the complexity and contradictions of a web of bilateral relations would outweigh any gains to be won from tougher negotiations. Mr Trump also needs to be persuaded that alliances are America’s greatest source of power. Its unique network plays as large a role as its economy and its military might in making it the global superpower. Alliances help raise it above its regional rivals—China in East Asia, Russia in eastern Europe, Iran in the Middle East. If Mr Trump truly wants to put America First, his priority should be strengthening ties, not treating allies with contempt.And if this advice is ignored? America’s allies must strive to preserve multilateral institutions for the day after Mr Trump, by bolstering their finances and limiting the strife within them. And they must plan for a world without American leadership. If anyone is tempted to look to China to take on the mantle, it is not ready, even if that were desirable. Europe will no longer have the luxury of underfunding NATO and undercutting the EU’s foreign service—the closest it has to a State Department. Brazil, the regional power, must be prepared to help lead Latin America. In the Middle East fractious Arab states will together have to find a formula for living at peace with Iran.A web of bilateralism and a jerry-rigged regionalism are palpably worse for America than the world Mr Trump inherited. It is not too late for him to conclude how much worse, to ditch his bomb-throwers and switch course. The world should hope for that outcome. But it must prepare for trouble.

NEW YORK – When Donald Trump was elected President of the United States, stock markets rallied impressively. Investors were initially giddy about Trump’s promises of fiscal stimulus, deregulation of energy, health care, and financial services, and steep cuts in corporate, personal, estate, and capital-gains taxes. But will the reality of Trumponomics sustain a continued rise in equity prices?

It is little wonder that corporations and investors have been happy. This traditional Republican embrace of trickle-down supply-side economics will mostly favor corporations and wealthy individuals, while doing almost nothing to create jobs or raise blue-collar workers’ incomes.

According to the nonpartisan Tax Policy Center, almost half of the benefits from Trump’s proposed tax cuts would go to the top 1% of income earners.

Yet the corporate sector’s animal spirits may soon give way to primal fear: the market rally is already running out of steam, and Trump’s honeymoon with investors might be coming to an end. There are several reasons for this.

For starters, the anticipation of fiscal stimulus may have pushed stock prices up, but it also led to higher long-term interest rates, which hurts capital spending and interest-sensitive sectors such as real estate. Meanwhile, the strengthening dollar will destroy more of the jobs typically held by Trump’s blue-collar base. The president may have “saved” 1,000 jobs in Indiana by bullying and cajoling the air-conditioner manufacturer Carrier; but the US dollar’s appreciation since the election could destroy almost 400,000 manufacturing jobs over time.

Moreover, Trump’s fiscal-stimulus package might end up being much larger than the market’s current pricing suggests. As Presidents Ronald Reagan and George W. Bush showed, Republicans can rarely resist the temptation to cut corporate, income, and other taxes, even when they have no way to make up for the lost revenue and no desire to cut spending. If this happens again under Trump, fiscal deficits will push up interest rates and the dollar even further, and hurt the economy in the long term.

A second reason for investors to curb their enthusiasm is the specter of inflation. With the US economy already close to full employment, Trump’s fiscal stimulus will fuel inflation more than it does growth. Inflation will then force even Janet Yellen’s dovish Federal Reserve to hike up interest rates sooner and faster than it otherwise would have done, which will drive up long-term interest rates and the value of the dollar still more.

If Trump takes his protectionism too far, he will undoubtedly spark trade wars. America’s trading partners will have little choice but to respond to US import restrictions by imposing their own tariffs on US exports. The ensuing tit-for-tat will hinder global economic growth, and damage economies and markets everywhere. It is worth remembering how America’s 1930 Smoot-Hawley Tariff Act triggered global trade wars that exacerbated the Great Depression.

Fourth, Trump’s actions suggest that his administration’s economic interventionism will go beyond traditional protectionism. Trump has already shown his willingness to target firms’ foreign operations with the threat of import levies, public accusations of price gouging, and immigration restrictions (which make it harder to attract talent).

The Nobel laureate economist Edmund S. Phelps has described Trump’s direct interference in the corporate sector as reminiscent of corporatist Nazi Germany and Fascist Italy. Indeed, if former President Barack Obama had treated the corporate sector in the way that Trump has, he would have been smeared as a communist; but for some reason when Trump does it, corporate America puts its tail between its legs.

Fifth, Trump is questioning US alliances, cozying up to American rivals such as Russia, and antagonizing important global powers such as China. His erratic foreign policies are spooking world leaders, multinational corporations, and global markets generally.

Finally, Trump may pursue damage-control methods that only make matters worse. For example, he and his advisers have already made verbal pronouncements intended to weaken the dollar. But talk is cheap, and open-mouth operations have only a temporary effect on the currency.

This means that Trump might take a more radical and heterodox approach. During the campaign, he bashed the Fed for being too dovish, and creating a “false economy.” And yet he may now be tempted to appoint new members to the Fed Board who are even more dovish, and less independent, than Yellen, in order to boost credit to the private sector.

To be sure, expectations of stimulus, lower taxes, and deregulation could still boost the economy and the market’s performance in the short term. But, as the vacillation in financial markets since Trump’s inauguration indicates, the president’s inconsistent, erratic, and destructive policies will take their toll on domestic and global economic growth in the long run.

In a political environment skewed by fake news and “alternative facts,” the real impact of President Donald Trump’s policies is easily obscured. At the recent Tarnopol Dean’s Lecture Series on the Trump administration and the economy, Wharton experts offered their unvarnished take on the impact of these policies on the capital markets, the dollar, economic growth and job creation — and backed them with analysis based on data.After closing above 20,000 for the first time, the Dow Jones Industrial Average has been giving back some of its gains of late amid a flurry of Trump mandates: escalation of a trade war with Mexico, anchored by a 20% tariff on its goods; making good on a promise to exit the Trans-Pacific Partnership trade deal in Asia; and instituting a temporary immigration ban on seven mainly Muslim countries that could hurt the quality of the U.S. workforce — especially in Silicon Valley — among others. Initially, the Dow was buoyed by Trump’s proposal to substantially cut corporate taxes, roll back many regulations and spend on infrastructure.“Investors and businesses very much like the Republican agenda. Notice I didn’t say the Trump agenda,” says Wharton finance professor Jeremy Siegel. “Why do they like the Republican agenda? Lower corporate taxes, less regulation, lower taxes on interest and dividend income. All that is very, very good for investors.”

Siegel lays out the bull case: “If there’s a significant corporate tax cut, and most people expect there to be one, that could add 10% to earnings in and of itself. So that alone, you could say, could give 10% to the stock market. In addition, you have a cut back in regulations, which is something again that both investors and businesses want, that could be another boost that some people say could be worth 10%.” He notes that those projections do not even include potential gains from infrastructure spending.

However, U.S. stocks have been whipsawed lately by Trump’s other orders. “What the market doesn’t like is most of the Trump agenda that is not part of the Republican agenda — clearly, big tariffs on imports, such moves as restricting immigration in a significant way, currency wars — anything like that is very anti-Republican,” Siegel says. The market has moved up “cautiously” because it is yet unsure whether Trump will follow the Republican path all the way. “I’m not going to put all my marbles there yet because anything can happen under Trump.”The bear case is that the economy will take a big drubbing if trade wars break out. Siegel says that many Republicans believe the high Smoot-Hawley tariffs in the 1930s that taxed thousands of imported goods led to the Great Depression. While Siegel himself — along with most macroeconomists — does not agree with that premise (believing the cause was monetary collapse and the Federal Reserve’s inaction), if protectionism does break out globally, it would be disastrous depending on its magnitude. “If there is a trade war, the market would react extremely negatively,” he says. “We’d be down 10% to 15%.”

Coming Trade War?

Wharton international management professor Mauro Guillen says protectionism is a “terrible idea.” Trade barriers have been enacted in the recent past, such as President Nixon levying a 10% tariff across the board in the early 1970s. “Every time you’re introducing protectionism, you’re hurting the consumer.”There’s also the issue of substitution. If a 20% tariff on Mexican goods was put in place, it is not certain that people would automatically buy more products that are made in America. “Some consumers and companies will say, instead of buying from Mexico, I’m going to buy from an American-based producer, or they could go to China or Indonesia, or Costa Rica,” Guillen adds. “It’s not clear how the issue is going to play out.”Moreover, many U.S. companies will have to scramble to adapt quickly to a major shift in rules. “Many other companies that source components from China will be caught off guard,” Guillen says. “They’ve been doing business, they’ve been making investments, they’ve been making decisions for a long time assuming a certain set of rules. Now, if those rules change overnight, they’re going to find themselves in a very difficult situation.”

Guillen further questions the rationale behind choosing to launch a trade war with Mexico, whose exports make up about 10% to 12% of the U.S. trade deficit. “Why pick a fight with Mexico? … The problem is broader than that.” He also points out that the 18% devaluation in the Mexican peso — since Trump won the election — could offset the 20% proposed tariff. Overall, Guillen says the larger question for Trump and his policies is this: “What are you trying to accomplish?”When it comes to trade, Siegel explains that Trump’s point is to level the playing field. “We let their goods in, but they don’t let our goods in. Or they put much more restrictions on our exports than we do on their exports. It is true if we get those countries to accept more of our exports, actually both of us would be better off. … We didn’t push hard enough” to get into their markets. However, Guillen points out these trade imbalances might be true for China, but not Mexico. “There is free trade both ways.”There is talk of instituting a “border adjustment” to further boost U.S. trade, says Siegel. The rule exempts exports of U.S. companies from taxes, but also reduces the deductions they can take on imports to lower taxable income. “This is a huge subsidy to exports, a huge tax on imports and every economist says that will cause the dollar to be stronger.”Siegel says some models see the dollar appreciating by as much as the actual corporate tax rate if the full terms of the border adjustment is adopted and the impact would be “mammoth.” Since the U.S. still imports more than it exports, he believes the net impact of this move will be to boost revenue. U.S. companies that make goods domestically and sell them abroad will be winners while big importers like Walmart are the losers.The dollar could appreciate by about 25% if the corporate tax rate fell to 20%, and the real value of imports and exports will be unaffected as exchange rates fluctuate, adds Kent Smetters, Wharton professor of business economics and public policy who was deputy assistant secretary for economic policy under President George W. Bush. (Siegel disagrees because he says it does not take into account global capital flows.)“But here’s the issue. Even though this creates a level playing field with France and other European countries that have a territorial VAT [value added tax], getting that through the WTO [World Trade Organization] — that will be the fight,” Smetters says. Some European companies get a VAT refund.Smetters says that back then, the Clinton administration instituted its own form of border adjustment, which the Bush administration inherited. However, the lawyer-stocked WTO ruled that it was illegal, he adds. “The lawyers understand statutory incidents” and have less insight into economic policies.

European Tensions

Europe is facing some deep divisions over economic and immigration policies as well. “Differences in opinion are getting bigger and bigger,” Guillen says. “On top of that comes Brexit [British exit from the European Union] but the most worrying is you do have populist parties, and their [support] is growing” in the upcoming European elections. These parties tend to be anti-immigrant and favor leaving the EU. Add to the conflagration the Italian banking crisis, a worsening situation in Greece and a youth jobless rate in some European nations of 45%.At least, the people who voted for Brexit got one thing right. “There’s this dogma in Brussels [EU headquarters] that more integration in Europe is the solution to every problem. I personally believe that’s not the case,” Guillen says. “The EU did not figure out exactly when to stop [centralizing decisions] and where to let in enough [national] decision-making.” Sharing one currency — over half of EU members use the euro — complicates the matter.However, Siegel believes no country will be leaving the Eurozone – the group that shares the currency. “If Greece didn’t leave the euro, no one’s leaving the euro. The idea is ludicrous that these [populist] parties in Italy are going to lead them out of the euro. The Italians remember the Italian lira [which at one point was trading at 2,500 to the U.S. dollar].” He notes that “if it weren’t for the immigration issue, there wouldn’t be Brexit.”

Immigration ReformIn the U.S., illegal immigration was a key issue for the Trump campaign. Trump has pledged to build a wall between the U.S. and Mexico to stem the flow of undocumented workers and somehow make Mexico also pay for it. But an analysis by Smetters actually shows that deporting these workers — estimated between 11 million and 12 million overall — would hurt the U.S. economy.Trump’s plan assumes that if these workers were deported, native-born workers would take over these jobs. “That’s just simply not empirically true,” Smetters says. “When you export undocumented workers, those [typically low-skilled] jobs really aren’t replaced by native born workers” but by automation.Moreover, the presence of undocumented workers raises the wages of those who can legally work in the U.S. “Undocumented workers tend to take on lower wage jobs that don’t require English and that don’t require as much social skills. That forces native-born workers to, in fact, trade up in terms of their education, in terms of their skillset.”Smetters adds that while undocumented workers tend to have lower skill levels, a third of legal immigrants have college degrees. Guillen says immigration overall drives innovation, with immigrants launching 24% of all tech ventures in the U.S. over the past two decades. “That speaks volumes about the dynamism of immigrants at the high end and low end.”Smetters does see Trump softening his stance on immigration once he builds his long-promised Mexican wall. “If he gets that political win … everything will be more negotiable.”Ironically, the Trump proposal that could get plenty of political headwinds might be the issue of infrastructure spending. Wharton Dean Geoffrey Garrett, who moderated the talk, surmised that hardline Republicans wouldn’t want to run up the deficit while Democrats wouldn’t want to help a major Trump initiative.Smetters says one answer is to focus on repairing existing infrastructure instead of building new ones. “Repairs have the highest ROI [return on investment],” he says, noting that more than 400 Pennsylvania bridges need inspection in the next two years. If they fall into disrepair, “the disruption to transportation there could be very large.”

With the future of NAFTA potentially in jeopardy, we take a closer look at the significance of this relationship and the possible effects of change.

Summary

With the future of the North American Free Trade Agreement (NAFTA) in question and the potential for new tariffs on the horizon, there is a need to understand the underlying factors that drive the dynamics of the U.S.-Mexico bilateral trade relationship. This is a complex relationship that can best be understood by examining case studies at the national level and evaluating select U.S. states’ economies and their relationships with Mexico as well as the states’ relationships to the federal government. The first of this two-part Deep Dive examines some of the areas where the United States has the upper hand in commodity trades. It also shows that Mexico is in a position to more equally negotiate with the U.S. in the automotive sector.

Mexico’s growing dependence on imports to meet domestic gasoline demand, combined with the U.S. being the principal supplier, gives the U.S. strong leverage in this area.

Mexico has multiple options for sourcing its steel; therefore, the U.S. cannot exercise much influence over Mexico in this area.

Both countries would struggle to replace corn trade, however, given the role of corn in the Mexican diet, shifts in corn trade are much more dangerous for Mexico.

The complex, shared production network in the automotive industry puts the two countries on more even footing at a negotiation table in this area.

Introduction

The trajectory of U.S.-Mexican bilateral relations has come into question with the election of President Donald Trump. He publicly campaigned on the promise of renegotiating or abandoning NAFTA (which has nearly eliminated trade barriers between the U.S. and Mexico) if acceptable terms were not reached. This issue remains at the forefront of U.S.-Mexico bilateral relations, which have become inundated with uncertainties.

The U.S.-Mexico relationship has always been a complicated one. Particularly low points in the bilateral relationship included a war from 1846 to 1848, U.S. seizure of massive amounts of Mexican land and an attack and subsequent seven-month occupation of Veracruz by the U.S. Navy and Marines in 1914. During much of this period in history, the two countries were on relatively equal geopolitical scales. However, while the U.S. catapulted forward in its economic and national development in the 20th century, a multitude of conflicts, internal power struggles and economic crises prevented Mexico from keeping pace with the U.S. The disparity between the geopolitical weight of these two countries grew. For much of the 20th century, the U.S. remained the uncontested power in North America, and in the 21st century, the world’s hegemon.

With the future of NAFTA potentially in jeopardy, the time has come to take a closer look at this bilateral trade relationship. To evaluate the economic vulnerabilities of the U.S. and Mexico relative to each other, it is necessary to begin by examining the basic fundamentals of their trading relationship. Two dimensions of this relationship require analysis. The first is the U.S.-Mexico relationship at the national level, which will be the focus of this Deep Dive. The second dimension is evaluating the economies of select U.S. states and exploring their relationships with Mexico as well as the states’ relationships to the U.S. federal government. This will be the focus of a future Deep Dive.

In the first installment of this two-part series, we take the opportunity to comparatively study trade advantages between the U.S and Mexico at the national level. Below, we present four case studies on strategic areas of U.S. interest and explain to what degree they will give the U.S. leverage over Mexico, and vice versa, in any future trade agreement negotiations. We do not yet know the final fate of NAFTA, or precisely how changes will arise. However, it appears very likely the agreement will be modified in some way. Through the case studies below, we aim to assess the amount of leverage the U.S. and Mexico would have over one another in the event NAFTA were renegotiated or outright abandoned.

Oil and Gasoline

We begin with a case study of oil and gasoline, which are particularly problematic for Mexico in the bilateral relationship. Mexico is not only losing its economic influence over the U.S. in this area, but it is also increasing its dependence on the U.S. Mexico produces and exports crude oil, and the U.S. is among its destinations. However, Mexico’s influence in this area of the U.S. economy has been in decline since 2003. In that year, U.S. oil imports from Mexico peaked at 1.8 million barrels per day (bpd), accounting for 18.2 percent of all U.S. oil imports. Since then, shipments of Mexican oil to the U.S. have fallen, both in terms of volume and share of total U.S. oil imports. The latest U.S. Energy Information Administration (EIA) figures through November 2016 indicate that Mexico provides the U.S. with 7.3 percent of its imported oil, totaling 573,000 bpd.

Mexico will not recover this lost space in the U.S. economy any time soon because the U.S. is becoming increasingly self-sufficient with energy production. First, U.S. shale production broke into the U.S. energy market in 2012 and has progressively gained space there. Additionally, U.S. oil production is not currently operating at full capacity, with production expected to increase this year and next. Current EIA estimates put 2017 production gains at 110,000 bpd and 2018 gains at 300,000 bpd. Meanwhile, Mexico’s state-owned petroleum company Pemex continues to experience production declines due to lack of investment, technological constraints, lower well pressure and decreasing revenue. The company’s database shows a continual decline of production from 3.37 million bpd in 2003 to 2.15 million bpd in 2016.

Parallel to these developments is Mexico’s heavy dependence on U.S. imports for refined gasoline. Due to declining production and increasing demand, Mexico has been increasing its gasoline imports. In the last decade, gasoline imports have more than doubled, with Mexico importing 204 million barrels in 2006 and 504 million barrels in 2016. Last year, according to Pemex, Mexico imported 62 percent of its gasoline. Six countries supplied these imports: the U.S., Netherlands, Spain, India, Bahamas, Netherlands Antilles, France and Trinidad and Tobago. However, the U.S. stands out among these suppliers as it provides 81 percent of Mexico’s imported gasoline. This means that roughly half the gasoline consumed in Mexico comes from the U.S., making Mexico highly vulnerable to any U.S. trade barriers that would affect gasoline trade. Ultimately, the U.S. does not need Mexican oil and thus Mexico cannot use control of this commodity to shape U.S. behavior. Conversely, the Mexican economy is very dependent on U.S. gasoline, so any change in the U.S. supply would impact Mexico’s economy and behavior.

We have also decided to examine the steel trade since returning steel workers’ jobs to the U.S. was one of Trump’s major campaign promises. The World Steel Association reports that the U.S. produces more than four times as much steel as Mexico while China produces 44 times more steel than Mexico. In general, Mexico is a net consumer of steel and not a net exporter. Therefore, it does not pose a direct threat to U.S. steel workers’ jobs.

According to the U.S. International Trade Administration’s most recent reports, the U.S. exported 6 million metric tons of steel in the first three quarters of 2016, which accounted for 11.3 percent of total U.S. steel production. Canada ranks as the top destination for exported U.S. steel at 51 percent (approximately 3.4 million metric tons) while Mexico ranks as the second largest destination at 39 percent (approximately 2.6 million metric tons). This marks a 5-point decline in Mexico’s share of U.S. steel exports from 2014, just two years prior. Overall, Mexico received only 4.3 percent of total U.S. steel produced from January through September 2016. Its share of total U.S. steel production is small and declining. Although China presents a large threat to U.S. steel production and employment due to its steel surplus, Mexico comparatively does not.

From the Mexican perspective, the U.S. International Trade Administration reports that U.S. steel accounts for 40 percent of Mexico’s total steel imports. Other leading sources of steel for Mexico include Japan (17 percent), South Korea (10 percent), China (7 percent) and Canada (5 percent). Mexico has also established steel trade ties with countries like Brazil, Germany, Russia, India, the United Kingdom and Spain. At first glance, this appears to give the U.S. trade leverage over Mexico in this area. However, the global steel market is currently oversupplied, so Mexico has other available options and can shift steel suppliers if the U.S. imposes unattractive trade barriers. The initial switch in suppliers may incur some short-term costs, but this is one limited area where Mexico enjoys a relatively high degree of maneuverability with potential suppliers.Agriculture

Mexico depends almost entirely on the U.S. for its imports of both soybeans and corn. Mexico meets only about 10 percent of its soybean needs domestically; the rest is imported. The U.S. Department of Agriculture (USDA) projects Mexico will produce 505,000 tons of soybeans in the 2016-17 season while consumption will be about 4.8 million tons. The U.S. accounts for 93 percent of Mexico’s imported soybeans, with the remaining 7 percent supplied by Paraguay. Mexico ranks as the second largest destination for U.S. soybean exports and received 3.84 million tons of soybeans from the U.S. in the 2015-16 season. This amounted to 7.8 percent of total U.S. soybean exports and pales in comparison to U.S. soybean exports to China, which account for 55 percent of total U.S. soybean exports. In the coming 2016-17 season, the USDA projects that Mexico will import 4.3 million tons of soybeans, about 4 million tons of which will come from the U.S. At the same time, the U.S. is expected to export 55.79 million tons, which would decrease Mexico’s share in U.S. soybean exports to 7.1 percent.

Even in the greater picture of world agricultural trade, the U.S. holds a slight advantage over Mexico in the area of soybean trade because Mexico will encounter more difficulty replacing the U.S. as a supplier than the U.S. will encounter in replacing Mexico as a buyer. While Mexico already imports some soybeans from Paraguay, it would be challenging for Paraguay to replace the U.S. as Mexico’s primary supplier. This is because Paraguay only exports a total of roughly 5.3 million tons of soybeans annually, which is equivalent to only a tenth of total U.S. soybean exports. If Paraguay became Mexico’s sole supplier of soybeans, Mexico would demand three quarters of Paraguay’s export supply – and getting a country to shift that amount of their commodity export is a tall order.

Mexican farmworkers hoe a cabbage field on Sept. 27, 2016, in Holtville, California. Thousands of Mexican seasonal workers legally cross the border daily from Mexicali, Mexico, to work the fields of Imperial Valley, California, some of the most productive farmland in the United States. John Moore/Getty Images

Furthermore, Brazil and Argentina produce 58.4 million tons and 9 million tons, respectively, but both of these countries export about 75 percent of their soybeans to China, whose demand for the crop is expected to continue growing this year. Little would be left over to export to Mexico if trade barriers made it necessary for Mexico to find a new supplier. Overall, global soybean production is not expected to increase dramatically this season, making it more difficult for Mexico to negotiate a share of soybean crops from other providers if the need arises. As for the U.S., 4 million tons of soybeans exported to Mexico is not significant compared to the 117 million tons the U.S. is projected to produce this season. Finding other buyers to absorb the extra 4 million tons would not be terribly difficult, given that world demand is not expected to drop.

When it comes to corn, however, a degree of interdependence exists between the U.S. and Mexico. As with soybeans, Mexico relies on imports to meet its corn consumption needs as it only produces enough domestically to meet about 63.3 percent of its needs, according to the International Grains Council. The USDA projects Mexico will produce 24.5 million tons of corn in the 2016-17 season while consumption will be approximately 38.4 million tons. Therefore, Mexico will need to import a significant amount of corn. The U.S. supplies 97 percent of Mexico’s imported corn, and the remaining corn imports are sourced from Brazil and Argentina. Mexico ranks as the leading destination for U.S. corn and received 13.58 million tons in the 2015-16 season. This amounted to 26.5 percent of total U.S. corn exports.

In the case of corn, the U.S. holds a great amount of leverage over Mexico. In part, this is due to the U.S.’ share in Mexico’s corn imports; it is also due, in part, to the importance of corn in the Mexican diet. In the 2016-17 season, the USDA projects Mexico will import 13.8 million tons of corn, of which about 13.39 million tons will come from the U.S. At the same time, the U.S. is expected to export 56.6 million tons, decreasing Mexico’s share of U.S. corn exports to 23.7 percent. Though feasible, it would be challenging for the U.S. to replace Mexico as a buyer of its corn and for Mexico to replace the U.S. as a supplier of its corn given the high volumes involved.

Mexico currently imports 261,956 tons of corn from Brazil and 12,557 tons from Argentina annually. Unlike with soybeans, which both countries export primarily to China, Brazil and Argentina, corn exports are destined for more diversified markets. No single importer accounts for more than 16.6 percent of Brazil’s corn exports and 14.4 percent of Argentina’s. Therefore, there is space for Mexico to negotiate a share of these exports. The USDA also projects that Russia and Ukraine will see a boost in corn production in the 2016-17 season that will translate into exports. If Mexico began to import its corn from other sources, the U.S. would also need to look to multiple markets to fully absorb the 13.8 million tons of corn that would no longer be exported to Mexico.

The prominence of corn in the Mexican diet tips the scales and gives the U.S. more leverage over Mexico when it comes to corn. Corn is considered a food grain, rather than a feed grain, in Mexico, meant largely for human consumption. Corn serves as a major food staple in Mexico, especially among the poor. As observed in 2007, the country is very sensitive to volatility in corn prices or speculation on supply. This can cause severe economic disruptions and hardships in households and business across the country. In the past, this has resulted in unrest and protests. For this reason, Mexico needs a secure, steady corn supply. Any threat to the stability of the corn supply becomes a strong vulnerability for the country.

Automotive

We now move to a more complex and sophisticated area of the U.S.-Mexico bilateral trade relationship: the automotive industry. The first three cases examined simple commodities. The analysis in those cases is relatively cut-and-dry based on supply and demand. The automotive industry, however, is much more complex and involves a high degree of value-added components. In this space, production requires extensive supply chains, multiple assembly phases, importing input materials and exporting the final product to the market. Therefore, this case study will be fundamentally different than the previous three.

The automotive industry plays an integral part in both the American and Mexican economies. Mexico is currently the seventh largest vehicle producer in the world, and the automotive industry accounts for 3 percent of the country’s GDP, according the U.S. Department of Commerce. In the U.S., the automotive parts industry directly employs 871,000 people, according to a recent report by the Motor & Equipment Manufacturers Association. This accounts for 2.9 percent of total U.S. jobs and 2.4 percent of U.S. GDP. Including indirect and employment-induced jobs, the automotive parts industry impacts an estimated 4.26 million jobs in the U.S.

In this case study, we make an important distinction between finished vehicles and automotive parts. The U.S. does not export a substantial number of finished vehicles to Mexico, but it does export a large volume of automotive parts. In 2015, the U.S. Department of Commerce reported that $81.1 billion worth of U.S. automotive parts were exported to the rest of the world, of which $30 billion were exported to Mexico. This represents 53 percent of all Mexican automotive parts imports and 38 percent of all U.S. automotive parts exports. However, Mexico also exported parts to the U.S., and these exports were valued at $50 billion. This is almost triple the value of Mexico’s next largest auto parts export market, Canada, which received $18 billion in auto parts in 2015. Mexico’s automotive parts industry is highly vulnerable to U.S. trade behavior while U.S. exposure to Mexico in this area is comparatively less.

Creating further U.S. leverage over Mexico is the fact that Mexico is highly dependent on the U.S. as an export market for completed vehicles. Of the 3.4 million light vehicles produced in Mexico in 2015, 2.8 million were exported, and the U.S. received 2 million of these exports. The U.S. market accounts for 72 percent of Mexico’s light vehicle exports and 59 percent of Mexico’s total light vehicle production. Mexico’s next largest export market, Canada, is significantly smaller and accounts for 10.5 percent of exports or 8.5 percent of total production. Additionally, a large portion of Mexico’s foreign direct investment (FDI) comes from the U.S. The U.S. contributed to 53 percent of Mexico’s $28 billion of FDI in 2015, according to a study by the Wilson Center. The automobile industry was the top recipient of U.S. FDI in Mexico, receiving about $6 billion. This amount of FDI would not be replaceable overnight, thus giving the U.S. more leverage over Mexico in the automotive trade relationship.

However, the vertical production chain shared by Mexico and the U.S. does create a scenario in which it may be in U.S. interests to continue trade and integrated production with Mexico in the automotive industry. It is difficult to break down the exact percentage of U.S. imports from Mexico that have parts of U.S. origin by industry because many components cross over the U.S.-Mexico border multiple times before the finished product is assembled. This is due to the specialized skill sets and competitive advantages that each country has in particular assembly steps. However, a paper published by the National Bureau of Economic Research in 2010 suggested that 40 percent of all imports to the U.S. from Mexico have parts of U.S. origin.

Even if a tariff was placed on Mexican imports, one could argue it would still be more cost-effective for U.S. companies to import completed vehicles from Mexico rather than restructuring the supply chain since Mexico still has some competitive advantages, such as lower labor costs and extensive infrastructure connectivity with the U.S. At the end of the day, however, a tariff is really an indirect tax that will affect the bottom line for U.S. companies. Depending on the level of these tariffs, U.S. companies may see reduced profits. The potential repercussions include fewer jobs and higher prices on finished goods, which would be felt by the American lower and middle classes.

The U.S. could also redirect its auto parts exports to the next largest vehicle manufacturer, China, but that is not necessarily the most viable option as U.S. exporters would face a separate series of Chinese tariffs. Reorganizing entire supply chains in a process as complex as automobile manufacturing is extremely difficult. Unlike grains – where you can find another supplier and buy the finished product as-is – there are many more costs and complicated logistics involved with revamping the automobile supply chain. Suppliers must have the workforce with sufficient expertise and technology to carry out their part of the process. This production is also dependent on factories, meaning that facilities must be located and properly outfitted for the specific production activity. The complexities of the production process make it difficult and costly to totally restructure. In this sense, Mexico and the U.S. have a type of mutual dependence on one another. Neither can break away from the other without incurring dramatic costs and threatening the livelihood of its automotive industry.

Conclusion

The three commodity case studies (oil and gasoline, steel, and corn and soybeans) illustrate that the U.S. and Mexico have an asymmetrical relationship with the U.S. being the stronger player. An exception is the case of the automotive industry, where closely integrated supply and production chains have resulted in an interdependence that is hard to break without suffering economic losses during the transition process. On a whole, when it comes to the bilateral trade relationship at the national level, the U.S. holds a much stronger hand at the negotiation table. When examining only the national level of the U.S.-Mexico bilateral trade relationship, it appears that Mexico will lose out if NAFTA is dissolved or significantly altered. However, this does not mark the end of our analysis as there are still reasons for Washington to avoid aggressively pursuing the reintroduction of trade barriers against Mexico. In our next Deep Dive, we will look at the cross-border trade of select U.S. states’ economies and their relationships with Mexico.

We are travelers on a cosmic journey, stardust, swirling and dancing in the eddies and whirlpools of infinity. Life is eternal. We have stopped for a moment to encounter each other, to meet, to love, to share.This is a precious moment. It is a little parenthesis in eternity.